A standby letter of credit (SBLC) is an undertaking by a bank to pay a beneficiary when the bank receives a demand stating that the bank's customer, the applicant, has failed to pay or perform an obligation. It is a form of letter of credit, but it is meant to stand by in case of default rather than to serve as the normal channel of payment. If the applicant performs, the standby expires unused.
In function the standby is very close to an independent demand guarantee, and the two are often interchangeable. Standbys developed in the United States, where banks were historically restricted from issuing guarantees, and are now used worldwide. They are usually issued subject to the International Standby Practices (ISP98) or the ICC Uniform Customs and Practice for Documentary Credits (UCP 600), and the issuing bank owes payment against documents, not against proof of what happened under the underlying contract.
Standby letter of credit in plain terms
A commercial letter of credit is like paying for a meal with a voucher: the voucher is how the restaurant gets paid every time. A standby is more like the credit card a hotel takes at check-in. The hotel does not charge it if you settle your bill, but if you leave without paying or damage the room, it can collect from the card company.
The person relying on the standby does not need to trust the customer, only the bank behind it. And the bank does not referee arguments about whether the customer really failed. If the right paperwork arrives on time, the bank pays, and it then recovers the money from its own customer.
Types of standby
- Financial standby. Backs a payment obligation such as repayment of a loan, rent, insurance premiums or trade payables. A supplier selling on open-account terms may ask for one to cover the buyer's invoices.
- Performance standby. Backs a non-financial obligation, such as completing a project. It does the job of a performance bond.
- Bid and advance payment standbys. Equivalents of a bid bond and an advance payment guarantee, used mainly by US applicants.
- Direct-pay standby. Used in some bond and commercial paper financings, where the standby is drawn routinely to pay interest or principal regardless of default.
- Counter standby. Issued to another bank to support a local standby or guarantee, the standby version of a counter guarantee.
Rules and law
ISP98, published by the ICC as Publication No. 590 and effective from 1 January 1999, was written specifically for standbys. It deals with matters that UCP 600 handles poorly for a default instrument, such as demands for payment made close to expiry, partial drawings, transfer and what happens when the bank is closed on the last day for presentation. UCP 600, in force since 1 July 2007, states that it applies to standbys to the extent its articles are relevant, and some banks still prefer it. A standby can also be issued under URDG 758, the rules for demand guarantees.
Underlying law also matters. In the United States, Article 5 of the Uniform Commercial Code governs letters of credit, including standbys. Internationally, the United Nations Convention on Independent Guarantees and Stand-by Letters of Credit, adopted in 1995 and in force since 1 January 2000, has been ratified by only a small number of states. Standbys are normally issued by authenticated SWIFT message, using the guarantee and standby message types such as the MT760.
Standby versus commercial credit and guarantee
| Feature | Commercial letter of credit | Standby letter of credit | Demand guarantee |
|---|---|---|---|
| Expected to be drawn | Yes, it is the payment method | No, only on default | No, only on default |
| Typical documents | Invoice, transport and insurance documents | Demand and statement of default | Demand and statement of breach |
| Usual rules | UCP 600 | ISP98 or UCP 600 | URDG 758 |
| Main users | Importers and exporters | US firms, lenders, landlords, insurers | Contractors and exporters outside the US |
Because standbys are payable on simple demand, applicants face the same risk of unfair calling as with guarantees. Courts will usually stop payment only for clear fraud.
Bank capital and pricing
A standby is off the issuer's balance sheet until drawn, but regulators treat it as credit exposure. Under the Basel standardised approach applied in Basel III, a financial standby is a direct credit substitute with a 100% credit conversion factor, while a performance standby tied to a specific transaction generally receives 50%. Fees therefore track the applicant's credit quality, and banks often require collateral or a committed facility. For the beneficiary, the standby converts credit risk on the applicant into counterparty risk on the bank, and it may be cheaper than trade credit insurance for a single large buyer.
The SBLC is a favourite prop in investment scams. Promoters offer to lease, monetise or trade standbys from top banks, promising huge returns from a secret market. No such market exists: genuine standbys are issued for a named beneficiary to back a real obligation and cannot be rented. These schemes are a variant of advance-fee fraud, and regulators including the US Securities and Exchange Commission have repeatedly warned investors about prime bank and standby-leasing offers.